ABC Analysis - Technique of Inventory Control

Graphical Representation of ABC Analysis

Graphical Representation of ABC Analysis
Graphical Representation of ABC Analysis

What is ABC Analysis

ABC analysis is a type of analysis of material dividing in three groups called A-group items, B-Group items and C-group items For the purpose of exercising control over materials. Manufacturing concerns find it useful to divide materials into three categories.

An analysis of the annual consumption of materials of any organisation would indicate that a handful of top high value items (less than 10 per cent of the total number) will account for a substantial portion of about 70 per cent of total consumption value.

Remember: 10% of total number of items carries 70% of value. - "A" group items

Similarly, a large number bottom items (over 70 per cent of the total number of items) account for only about 10 percent of the consumption value.

Remember: 70% of total number of items account for only about 10% of consumption value - "C"-group items.

Between these two extremes will fall those items the percentage number of which is more or less equal to their consumption value.

Remember: 20% of total number of items account for only about 20% consumption value - "B" group items.

Items in the top category are treated as "A" category items. Items in the bottom category are called as "C" category items and the items that lie between the top and the bottom are called "B" category items. Such an analysis of materials is known as ABC analysis or Proportional parts value analysis.

Classification of items into A, B and C categories

The logic behind this kind of analysis is that the management should study each item of stock in terms of its usage, lead time, technical or other problems and its relative money value in the total investment in inventories.

Critical items i.e., high value items deserve very close attention and low value items need to be devoted minimum expense and effort in the task of controlling inventories.

The Material Manager by concentrating on "A" class items is able to control inventories and show visible results in a short span of time. By controlling "A" items and doing a proper inventory analysis, obsolete stocks are automatically pinpointed.

ABC analysis also helps in reducing the clerical costs and results in better planning and improved inventory turnover. ABC analysis has to be resorted to because equal attention to A, B and C items will not be worthwhile and would be very expensive.

The following steps will explain to you the classification of items into A, B and C categories.

The following steps will explain to you the classification of items into A, B and C categories.

1. Find out the unit cost and and the usage of each material over a given period.
2. Multiply the unit cost by the estimated annual usage to obtain the net value.
3. List out all the items and arrange them in the descending value. (Annual Value)
4. Accumulate value and add up number of items and calculate percentage on total inventory in value and in number.
5. Draw a curve of percentage items and percentage value.
6. Mark off from the curve the rational limits of A, B and C categories.

Stock Levels


Maintenance of proper stock of each item of materials is one of the main functions of stores department. Large quantity of material in store lead to huge investments, deterioration in quality, large space requirement etc. Less stock also leads to higher costs, frequent purchases and loss of production etc. Therefore, it is important to maintain stock level. One of the best way to maintain stock is to determine the minimum and maximum stock levels as per the necessity and maintain it regularly.

Store keepers usually use scientific technique of material management to ensure optimum quantity of material in store and make purchases accordingly. In order to do that following levels are fixed in advance:

  1. Maximum Stock Level
  2. Minimum Stock level
  3. Re-ordering level
  4. Danger level

Reordering Level

Re-ordering level is a level at which the storekeeper will initiate the steps to purchase fresh supplies. This level is called re-ordering level or ordering level. This level usually lies between minimum and maximum stock level. This level will usually be higher than the minimum stock level to cover unexpected delay in delivery of fresh supplies or abnormal usage of materials. Following points need to be taken into consideration while fixing the re-ordering level

1. Economic ordering quantity
2. Rate of consumption
3. Time required for the delivery of fresh supply.

Following formulas can be used for calculating the re-ordering level.

Reorder level = Maximum consumption x Maximum re-order period

or

Reorder level = Minimum level + consumption during the time required to get fresh deliveries

Example 1

Calculate the reorder level from the following information:
Maximum Consumption = 100 units per week
Minimum Consumption = 50 units per week
Maximum reorder period = 4 weeks

Solution:

Reorder level = Maximum consumption x Maximum reorder period
= 100 x 4 = 400 units.



Example 2
Find out the order level from the following information:
Maximum Stock: 250 units
Minimum stock: 100 units
Time required for receiving fresh supplies: 10 days
Daily consumption of material : 5 units

Solution:

Reorder level = Minimum level + consumption during the time required to get fresh deliveries
= 100 + (5 x 10)
= 150 units.

Minimum Stock Level

Minimum stock level is a level of stock which must be kept in store at all times. This is a level of an item of material below which the stock in hand is not allowed to fall. The objective of this limit is to avoid the possibility of interruption of production due to shortage of material. The following points needs to be taken into consideration while fixing the minimum stock level.

  1. Time required for the fresh supply of material - Lead time
  2. Rate of consumption of material during the lead time.
  3. Reorder level

Following formula can be used for determine the minimum stock level

Minimum stock level = Reorder level - (Normal consumption x Normal reorder period)

Example:
Calculate the minimum stock level from the following data:
Net normal consumption = 500 units per day
Normal reorder period = 10 days
Reorder level = 8000 units

Solution:
Minimum stock level = Reorder level - (Normal consumption x Normal reorder period)
= 8000 - (500 x 10)
= 3000 units

Maximum stock level

Maximum stock level is a quantity of material above which the stock of any item should not be allowed. To avoid blocking of working capital and making undue investments in stock, maximum stock level is to be fixed. It also helps to maintain proper quality of raw materials. Following points must be taken into consideration while fixing maximum stock level:

  1. Availability of storage space
  2. Cost of carrying the inventory
  3. Amount of working capital available
  4. Economic ordering quantity
  5. Possibility of change in market trend
  6. Normal rate of consumption of material during the reordering process.
  7. Time necessary for fresh delivery of materials.
  8. Possibility of loss due to deterioration/evaporation etc.
  9. Price fluctuation.
  10. Insurance costs if any.

Following formula is normally in use for calculating Maximum stock level.

Maximum stock level = Reorder level + reorder quantity - (maximum consumption X minimum re-order period)

Example:
Find out the Maximum stock level from the following information:
Reorder Level = 32000 units
Reorder quantity = 30000 units
Minimum Consumption = 3000 units per month
Minimum reorder period = 2 months.

Solution:
Maximum stock level = Reorder level + reorder quantity - (maximum consumption X minimum re-order period)

Maximum stock level = 32000 + 30000 - (3000 x 2)
=62000 - 6000 = 56000 units.

Danger Level


Danger level is a level below the minimum level. This is a level at which urgent action must be taken to procure new stock otherwise the stock may exhaust and could affect the production. This level is calculated by taking into account the time required to get the materials by the shortest possible means. Generally following formula is used to calculate the Danger level:

Danger level = average consumption x Maximum reorder period for emergency purchase.

Average stock level

Average stock level can be determined by using the following formula:

Average Stock Level = 1/2 of (Maximum stock level + Minimum Stock level)

or

Average Stock Level = Minimum stock level + half of reorder quantity)

Reorder Quantity or Economical order Quantity


It is better to determine in advance how much is to be purchased when the material reaches reorder level. This quantity is called reorder quantity. It is the quantity when it received, it will not exceed the maximum stock level. It is also called Economic Order Quantity because purchase of this quantity of material is most economical as well. Frequent purchase will result in increase in cost of transportation. Too much of goods may block the working capital for a long time. Following points needs to be taken into consideration while fixing the reorder quantity.

  1. Cost of transportation
  2. cost of storage (warehouse rent, insurance, heating and lighting expenses)
  3. cost of ordering
  4. Availability of working capital
  5. minimum and maximum consumption for the lead time.
  6. Time necessary to obtain deliveries
  7. Possibility of loss due to evaporation or deterioration
  8. Changes in the fashion trend.
  9. Interest on investment
  10. Obsolescence losses,
  11. Store staff expenses.


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Comments 7 comments

teja 4 years ago

very useful


venkatesan 4 years ago

i am utilising this analysis my examination point of view.

very nice


Kamlesh K S 4 years ago

This is very Important for those people who are going for material management.


kmekh 4 years ago

Very useful thanks. One problem : is it Minimum or Maximum Consumption taken to calculate Maximum stock level ?


williamline30@yahoo.com 4 years ago

contented


devender 4 years ago

we can understand that we need minimun level for reorder level but for calculte for minimum level we also need reorder level


situla situla 4 years ago

this is the best information i waned .please continue with this . student at evelyn hone college ,zambia.

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